The case for buying or continuing to hold the shares of Yahoo! (NASDAQ:YHOO) continues to look strong, with the understanding that 1) operationally the company remains a work in progress, and 2) its valuation derives from assumptions about realizable values of its ownership of two Asian properties. Nonetheless, I like what I see.
I last wrote about YHOO in a Seeking Alpha article published on March 7, titled Yahoo's Stock Takes Aim At $30. The March 6 price (when I wrote the article) was $22.80. It is now $23.95. Thus, for what it's worth, it has outperformed the S&P 500 index by a factor of 4, showing that the Street has continued to like what it sees. That article followed only shortly after one I wrote that SA published on Feb. 28, Yahoo Stock Is Too Cheap. The reason for the quick follow-up piece was that in early March, analysts revised materially higher their estimate of the value of Yahoo's Asian shareholdings. Thus on March 7, though YHOO was trading well above its late February level, this revaluation higher actually left YHOO a better buy at a higher price than it had been at a lower price.
This article further updates a sum-of-the-parts of analysis and argues that a reasonable case can be made that YHOO is worth more than its current price to an acquirer, though it's difficult to put a number on its takeover value. Operational and other matters are also discussed.
Overall, I believe that shareholders have two ways to win here, either due to the underlying values that could make YHOO the subject of a bidding war if it comes into play, or because operations could turn around to allow the company to realize a premium valuation on growing earnings.
Technical condition: It's impressive that YHOO has been outperforming the market:
|Compare:||YHOO vs S&P 500 Nasdaq Dow|
The stock was going nowhere fast until the Q3 earnings report, which came shortly after newly-installed CEO Marissa Mayer returned from a brief maternity leave to try to reshape the company. Roughly ever since then, the stock has steadily outperformed its benchmarks. This has occurred even though "officially", analysts continue to be at best lukewarm on the stock. This suggests to me that either good vibes from Silicon Valley are outweighing the official analyst recommendations, or they're just for public consumption.
This surge is of course a small reversal of fortune, when looked at on a long-term basis:
|Compare:||YHOO vs S&P 500 Nasdaq Dow|
Since going public in 1996, YHOO has appreciated at a strong 18.5% annual rate, but if AAPL and gold owners are bemoaning their asset's selloffs, they should consider how one of the hottest stocks of the late bubble era has gone nowhere for so many years. As an aside, I like the structure of this chart. It looks to me as if the stock "wants" to continue to go vertical. But that's just the way I see it, and any corporate stock can go anywhere at any time.
Earnings: These are mentioned to suggest that the time is not ripe to pay overly-much attention to Yahoo's absolute number or trend. That time may come, but there are numerous moving parts that make quarter-to-quarter and year-on-year comparisons difficult. In Q1, for example, earnings, which surprised sharply to the upside in Q1, gained in part because of headcount reduction, deferred capital spending, varying tax rates, and strong equity earnings in the Asian subsidiaries.
In addition, the sum-of-the-parts analysis must, by definition, exclude the contributions from the Asian equity interests.
Deconstructing YHOO's asset value: YHOO can be valued as its quick liquidating value (untaxed return of capital, in an unhurried liquidation), plus the after-tax value of its equity interests in Alibaba.com and Y!Japan (Yahoo! Japan). Following a large share buyback last quarter, there are 1.11 B shares outstanding.
Yahoo owns 24% of the very large and fast-growing Alibaba Internet-based trading company, and 35% of Y!Japan. First, from Yahoo's latest SEC filing, its asset value is $7.5B. This derives from its consolidated balance sheet:
Yahoo! Inc. Unaudited Condensed Consolidated Balance Sheets (in thousands) December 31, March 31, 2012 2013 ASSETS Current assets: Cash and cash equivalents $ 2,667,778 $ 1,174,633 Short-term marketable debt securities 1,516,175 1,838,527 Accounts receivable, net 1,008,448 943,658 Prepaid expenses and other current assets 460,312 644,204 Total current assets 5,652,713 4,601,022 Long-term marketable debt securities 1,838,425 2,382,026 Alibaba Group Preference Shares 816,261 830,925 Property and equipment, net 1,685,845 1,612,690 Goodwill 3,826,749 3,803,433 Intangible assets, net 153,973 136,610 Other long-term assets 289,130 239,427 Investments in equity interests 2,840,157 2,884,846 Total assets $ 17,103,253 $ 16,490,979 LIABILITIES AND EQUITY Current liabilities: Accounts payable $ 184,831 $ 110,162 Accrued expenses and other current liabilities 808,475 720,463 Deferred revenue 296,926 308,462 Total current liabilities 1,290,232 1,139,087 Long-term deferred revenue 407,560 370,414 Capital lease and other long-term liabilities 124,587 121,475 Deferred and other long-term tax liabilities, net 675,271 674,077 Total liabilities 2,497,650 2,305,053 Total Yahoo! Inc. stockholders' equity 14,560,200 14,139,915 Noncontrolling interests 45,403 46,011 Total equity 14,605,603 14,185,926 Total liabilities and equity $ 17,103,253 $ 16,490,979
Out of total equity of $14.2 B, I am only including all current assets, long-term marketable debt securities, and about 1/3 of all property-plant-and-equipment. This amounts to about $7.5 B. Because we are going to estimate the value of the company's equity interests in Asian companies, we'll omit any of those lines on the balance sheet to avoid double-counting.
Next, we have an updated estimate of Yahoo's stake in Y!Japan, as discussed on the conference call. The CFO, Ken Goldman, stated that this was about $9.3 B at the end of the quarter. Subtracting 40% for taxes gives a value of $5.6 B. So the running total of this plus quick (but not forced) liquidating value is at $13.1 B. This is interesting, because YHOO's market cap closed Monday at $26.5 B.
Now let's guess at the privately-held and secretive Alibaba's possible value. For this, I need to rely on estimates from analysts. Barron's addressed this after earnings in a blog post titled YHOO: Merrill Ups to Buy; Bull and Bear Transfixed by Alibaba on April 17. Here are comments from it:
(Merrill analyst): "We are increasing our valuation estiamte (sic) to $80 billion from $60 billion, which is near the midpoint of our colleague Eddie Leung's valuation scenario range of $60 billion to $90 billion." He notes the company's new CEO will start on May 10th, prompting speculation of a lead up to an Initial Public Offering for the Chinese e-commerce firm.
Perhaps the most relevant updated guess at Alibaba's value comes here:
Ken Sena, Evercore Partners: Reiterates an Equal Weight rating and raises his price target to $27 from $22. "Although an update on Yahoo!'s 24% stake in privately-held Alibaba was not provided on the call, we use this opportunity to
reexamine our Alibaba valuation work in light of growing evidence that our $40bn prior estimate was insufficient. Specifically, examining Alibaba's growth, scale, and rate of monetization amongst major peers leads us to forecast a 50% higher valuation, now $60bn, or 40% of Yahoo!'s closing share price after taxes [...] In truth, our work suggests an $80bn-$100bn valuation to be more appropriate in the context of its current growth and 3P scale (each roughly 3x Amazon's).
These appear to be the most recent valuations; the Barclay's analyst commented on a prior value of Alibaba of $55 B. I am going to use the the midpoint of the Merrill analyst's range of $75 B, which is slightly below the lowest part of the Evercore guess at Alibaba's "real" valuation. If we use $75 B, then Yahoo's 24% share is worth $18 B pretax. Subtracting 40% for taxes gives $10.8 B for Yahoo's realizable value from its Alibaba stock.
We were previously at $13.1 B. Adding $10.8 B to this gives an asset value for YHOO of $24.1 B. The total market cap for YHOO is $26.5 B. This only leaves $2.4 B for the value of this famous company. Is this close to realistic? Let's explore what Yahoo would be worth if it put itself up for sale tomorrow. Would an acquirer who believed the above numbers be willing to pay much for this company? To address that, let's look at the rest of the balance sheet and earnings report with the Q&A.
Balance sheet - Additional factors: To start with, I omitted intangibles and goodwill of $3.94 B. This valuation has survived multiple CEOs and a changed board of directors. Return on equity would be automatically approved by writing those amounts down. After all, the new CEO would simply be "correcting" a predecessor's alleged error. But the valuations have survived and must be respected.
Franchise value: Keeping the rest of the valuation big picture, the entirety of this and prior Seeking Alpha earnings reports plus Q&A's, plus other statements from Yahoo!, prove that there is massive user engagement with this company. How much would it be worth to (name your interested acquirer) to have immediate access to hundreds of millions of viewers daily or weekly? How much would it be worth to not let your direct competitor have that same access?
Getting more granular, Yahoo! may be the only major company that has partnerships with all of the following: Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT) and Facebook (NASDAQ:FB). Pretty good! The total market cap for those companies is, very roughly, one trillion dollars. All of them must constantly be updating what they would pay in a bidding war for Yahoo!.
Given an enterprise value of perhaps only a couple of billion dollars, my guess is that the real enterprise value of this company to an acquirer is much more than that. I need to leave guesses as to how much more to others who are more conversant with the appropriate metrics, though.
Operations: This is a transformed Yahoo! both in its management and its board (I discussed the latter at some length in my Feb. 28 article). Ms. Mayer and top lieutenants Goldman and deCastro were all senior Google executives before joining Yahoo!. I believe they are turning the company's operations around. More importantly, I believe that they believe that to be true. This attitude is expressed throughout the earnings presentation and Q&A. (Even more important, the stock market obviously isn't fighting that idea.) They point to much greater recent interest in job applicants joining Yahoo! than before. They point to improvements in user metrics at the Yahoo! home page and on mobile devices. Marissa Mayer's response to a question near the end of the Q&A was quite interesting:
Stephen Ju - Credit Suisse
Thank you. So, Marissa, curious about your next sprint and the timing of product rollouts and that you have sharpened the focus for your staff is already pretty well understood by investors. but is there anything you can share with us in terms of Yahoo!'s ability to accelerate the time to market for your new products and how quickly your engineers can iterate and refine once you have released a product on to the market?...
Marissa A. Mayer
In terms of the next sprint, this is really the fun part. This is where we get to really think about how can we inspire and provide our users and how can we provide them with amazing features. And I think that one of the things we've really focused on in this first part that was really focused around talent and getting the engine fit as I would call it is the - that we can really establish a cadence where we're not just updating our products once a year or once every few years. So we're really making continuous improvements and adjustments over time. So I really think what you're going to see is that Yahoo!'s products will be releasing with small changes much more frequently and there'll even be what I would call version updates, much more frequently, particularly on mobile and on the website. So I think we are in position to have a really nice cadence over the next few quarters of launches, ideally several launches a month if not at least a launch a week, if not more, across the product portfolio. (Emphasis added)
She is describing continuous process improvement. Great! (How I wish that Apple had done that!)
What's so great for me as a shareholder is that for her, the process of improving their products weekly is "the fun part". In other words, she's a geek running a geeky company. Plus she and the board are in accord to shrink headcount as much as possible to improve profitability. Yahoo! needed to go on a diet; it was bloated; that's changing rapidly. This attractive woman may be tough as nails despite her glamour. She continues to strike me as having similarities to Steve Jobs. We know she's interested in style, as he was; she only wants "A" players on her team, as he did; and she loves the technical world. Plus it's apparent that she shares his competitive drive. Steve Jobs didn't need to turn Apple around, and this first-time mother never needed to work again.
Elsewhere in the SA transcript, management mentions that they are looking to improve operations country-by-country. This may be very important, as Yahoo! is largely a U.S. company by revenues. There may be massive opportunities for the company in the rest of the world.
Finally, in this very brief discussion of certain operational aspects, Ms. Mayer emphasizes more than once that Yahoo! is operating in a growth industry. This aspect is something that we must remember when we look at market share losses for Yahoo!. Internet usage contains to grow, even in the most developed markets. Yahoo! is focused on the rapidly-growing mobile Internet, where neither Google nor Facebook (and certainly not Microsoft or Apple) have a lock on future dominance.
When a company operates in a true growth field, it gets do-overs that a company in a mature industry simply does not get. Market share losses are not necessarily so terrible in a fast-growing industry.
So I'm comfortable giving this board and this management team enough time to first bring the company to a state in which it is growing as fast as its overall market and then try to gain share. This is, obviously, a difficult task. My guess is that they will succeed, and my other guess is that if they do not, the company will be sold.
Risks: The valuations of the Asian subsidiaries are speculative and subject to downside reality checks that could be substantial. A turnaround is not assured operationally at Yahoo! by any means. The stock is up over 50% from last year's lows; the broad stock market is extended as well: corrections would be unsurprising. Also, the company's cash hoard might be wasted in share buybacks if matters do not go well for the company.
Other risks exist, of course.
Summary: YHOO is arguably worth a good deal more to an acquirer than its current trading value, as discussed above. It is difficult to name the number of large, deep-pocketed companies that would love to acquire both Yahoo!'s user base and its famous brand name. A hot IPO for Alibaba could actually make the company's quick liquidating value greater than its current valuation.
Separately from that, the company is pursuing an aggressive strategy of share buybacks and a comprehensive overhaul of its operations. It operates in one of the most dynamic sectors of the global economy that one can imagine; yet its operations are so heavily weighted to the U.S. that one hesitates to imagine its profitability if it could become a serious player in the global Internet.
I therefore suggest that either dead or alive, YHOO shares have enough underlying value and the company has so much growth potential that the risk-reward ratio is positive for shareholders despite the stock's surge over the past year.
Additional disclosure: I am not an investment adviser. Nothing herein constitutes investment advice.